What it means
Governments do not borrow only through their treasury. Agencies and government sponsored enterprises set up to support housing, farming, student lending or export finance also issue their own debt, and that debt is known collectively as agency securities.
The backing behind them is not uniform. Debt of a true government agency usually carries the full faith and credit of the government, while debt of a government sponsored enterprise is privately owned and carries only an implied expectation of support, and that difference is the source of the extra yield.
They come in two broad shapes. Agency debentures are plain bonds paying a coupon and repaying principal at maturity, while agency mortgage backed securities pass through the monthly payments made by thousands of underlying home loans.
Investors use them as a middle rung on the risk ladder. A corporate treasurer who wants more income than government bonds offer, without taking on corporate credit risk, buys agency paper and accepts the small extra yield as payment for slightly thinner liquidity and a less certain guarantee.
The nuance with mortgage backed agency paper is prepayment risk. When interest rates fall, homeowners refinance and the investor's money comes back early at exactly the moment it can only be reinvested at lower rates, which makes the effective maturity of the holding uncertain.
Spreads are quoted in basis points over the equivalent government bond, where one basis point is one hundredth of a percentage point. That spread widens when investors worry about liquidity or support and narrows when they do not, so it works as a quiet indicator of market stress.
In practice
Real-world examples.
Example
A corporate treasurer building a five year ladder splits $20,000,000 between government bonds and agency debentures. The agency portion adds about 30 basis points of yield, worth roughly $30,000 a year on a $10,000,000 allocation, with credit risk the board is willing to accept.
Example
An insurer buys agency mortgage backed securities to match long dated policy liabilities. Its actuaries model prepayment behaviour explicitly, because if homeowners repay early the insurer is left reinvesting at lower rates with liabilities that have not shortened at all.
Example
A bank holds agency paper in its liquidity buffer and pledges it as collateral in repurchase agreements. The lender applies a 2% haircut rather than the 0.5% it would apply to government bonds, which tells the treasurer exactly how the market ranks the two.
Formula
Calculation
Yield spread in basis points = (Agency yield - Government bond yield) x 10,000
Extra annual income = Principal x (Agency yield - Government bond yield)
A corporate treasurer has $5,000,000 to invest for five years. A five year government bond yields 3.90% and a five year agency note of the same maturity yields 4.20%. The spread is 4.20% - 3.90% = 0.30%, which expressed in basis points is 0.30% x 10,000 = 30 basis points. Extra annual income is $5,000,000 x 0.30% = $15,000, giving $15,000 x 5 = $75,000 across the full five years. The treasurer then has to judge whether $15,000 a year is fair payment for a holding that is a little harder to sell quickly and carries a guarantee that is implied rather than stated in law.Case study
Seen in the real world.
This is an illustrative, fictional example. Brightwater Logistics, an invented freight company, held $12,000,000 of cash reserved for a depot purchase expected in about two years. Its treasurer moved $8,000,000 of it into agency mortgage backed securities to pick up an extra 45 basis points of yield, worth $36,000 a year.
When the depot deal came forward by eight months, the treasurer had to sell. Prices had moved against the holding and the market for that particular issue was thin, so the sale realised $7,840,000, a loss of $160,000 that wiped out more than four years of the extra income the trade was meant to earn.
The illustrative lesson is not that agency securities are bad investments. It is that the extra yield is compensation for liquidity and maturity risk, and cash with an uncertain call date should sit in instruments that can be sold on any day without a price concession.
Watch out
Common mistakes.
- Treating all agency debt as identical to government bonds, when some issuers carry explicit backing and others only an implied expectation of support.
- Ignoring prepayment risk on agency mortgage backed securities and assuming the stated maturity is the real one.
- Chasing 30 or 40 basis points of extra yield with cash that may be needed at short notice.
Questions
People also ask.
Are agency securities risk free?
No investment is, although credit risk on this paper is generally considered very low, with the real exposures being interest rate moves, liquidity and prepayment behaviour.
Why do they yield more than treasury bonds?
Partly because the guarantee may be implied rather than explicit, and partly because individual issues trade in smaller, less liquid amounts.
How are they taxed?
Treatment varies by issuer and jurisdiction, with some agency interest exempt from certain local taxes and some fully taxable, so check the specific issue rather than assuming.
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